Higher long-end Treasury yields are unlikely to retreat anytime soon, and a host of intertwined supply and demand factors will likely hamstring U.S. policymakers seeking to cap borrowing costs.
That is because the renewed surge in rates reflects immediate concerns about the inflation picture in the U.S., alongside longer-term questions centering on how the market will absorb a flood of bonds sold by governments and high-quality corporate issuers, as well as a shift in the makeup of buyers to groups more likely to demand higher rates.
Treasury Secretary Scott Bessent, now deploying all the tools at his disposal to try to pull down those long-term borrowing costs, may find those structural issues offer the biggest challenge of all, bond investors say.
“Until global governments, including the United States, deliver a credible plan to address the massive and growing deficits, the bond market is saying, ‘Sorry, we can’t lend to you, or, if we do, it’s going to cost you a lot more money,'” said Arif Husain, head of global fixed income investing for T. Rowe Price.
Husain believes the change in the makeup of the buyers at such a critical time will make Bessent’s attempts to push longer-term yields especially challenging.
“There’s a supply/demand mismatch in the cash bond market, with fewer price-insensitive buyers willing to take that Treasury supply without being offered higher yields to do so,” he added.
REPRICING TREASURY RISK
The biggest part of the change, bond market participants say, comes in the term premium, or the portion of the yield that reflects investors’ willingness to commit capital for decades.
No one expects the U.S. to default, but the U.S. fiscal picture is deteriorating, with federal government debt topping $40 trillion. A higher term premium and heightened inflation expectations explain part of the backup in rates, market participants say.
“Bond investors increasingly question the safety of U.S. Treasuries, and they have re-priced Treasuries as a risky claim,” Hanno Lustig, a finance professor at Stanford University and senior fellow at the Stanford Institute for Economic Policy Research, said in an August 20 paper.
His research documents the rise of hedge funds and other price-sensitive firms as supplanting official, longer-term, less-sensitive buyers such as overseas central banks. Those shifts in who acts as the marginal buyer of government bonds have increased the price sensitivity of the market and fed volatility in long-term Treasury bond prices that can amplify the forces driving up interest rates.
Another major dynamic is playing out: corporate issuers, led by firms at the center of the AI data center buildout, are borrowing at a rapid clip: Wall Street expects big tech firms will spend more than $730 billion on AI infrastructure this year, up from last year’s $400 billion, and a large amount of that will be borrowed.
Their fundamentals – strong earnings growth, plenty of free cash flow – strike many investors as more appealing than the federal government’s.
As the Treasury market competes for the same pool of long-term capital as investment-grade corporate issuers perceived to have stronger credit fundamentals, investors are voting with their dollars and pushing spreads between the two categories to extremely narrow levels, said Thierry Wizman, global FX and rates strategist at Macquarie.
“To some extent, investors see (corporate) debt as safer,” said Wizman.
True, companies – unlike national governments – do present a default risk. But that appears to be slim for the kind of issuers now tapping the long-term debt markets, investors say.
Corporate profits from companies in the Standard & Poor’s 500 index (.SPX), opens new tab soared 52% in the second quarter, FactSet data show, bringing company profits as a share of GDP to a record 13.2%, according to the Bureau of Economic Analysis.
WATCHING THE TREASURY BUYERS
Others believe it’s a mistake to focus solely on the argument that hyperscaler debt issuance is “crowding out” Treasury bonds and driving yields higher. In their view, the demand side, which has been changing steadily in recent years, is playing an increasingly important role.
The change in the market’s structure described by Lustig has made Treasury bonds more vulnerable to periodic supply-demand imbalances and, on the margin, to higher yields, said Ryan Swift, U.S. bond strategist at BCA Research.
“That is not something that has happened in the last few months,” he said. “It has happened in the last couple of decades.”
The uncertain picture around inflation, especially given the impact on energy prices of the unresolved conflict with Iran, is an aggravating factor, investors agree.
The one certainty, they add, is that the nature of these issues likely will make it tough for Bessent and the Treasury Department to achieve lower long-term rates, as both supply and demand issues are beyond their control.
“Nobody has the stomach to make any tough choices about bringing the debt under control, and inflation is still well above the Fed’s target,” said Mike Goosay, chief investment officer for fixed income at Principal Asset Management.
